This article will show a simple way to monitor fixed income investors entry and exit from the high risk market to the low risk market. High Yield Bonds (Junk Bonds) are considered high risk, since the companies a high yield fund is investing in have lower credit ratings than investment grade or treasury bonds. On the opposite end of the spectrum are US treasury bonds, no real credit risks exist with these funds. When economic situations are turning down fixed income investors flee high risk bonds, and move to bonds with low or no risk. In this article we will take a look at how a simple fund switching strategy has performed recently using ETFs, and then move on and look at the performance since 1969 using index data.
Using a simple moving average we will monitor when investors are fleeing junk bonds, and moving to treasury bonds by examining the ratio of how junk bonds are doing compared with treasury bonds. We will test a strategy that switches between JNK [SPDR Barclays Capital High Yield Bnd ETF] & IEF [iShares 7-10 Year Treasury Bond ETF], based on if the price of the JNK fund is above or below a 130 day moving average.
JNK[SPDR Barclays Capital High Yield Bnd ETF] & IEF [iShares 7-10 Year Treasury Bond ETF] Switching Results
Simply switching a high yield bond fund to a treasury fund when the price of JNK is falling has resulted in significant performance, 11.84% annual return, with a high 1.88 Sharpe Ratio, and only 7% monthly drawdown.
Long Term Testing
Due to limited history this strategy may be suspect, we only had one large downturn in the market during this time period. Fortunately we can backtest using index data from Bank of America and Barclays back to 1969. We will use the same ratio of the US High Yield to Intermediate Term Treasury, and switch funds based on the same 130 day moving average.
US High Yield Data Index: BofA Merrill Lynch US High Yield Master
Intermediate Term Treasury Data Index: Barclays US Government Intermediate Term
The worst year for the moving average timing strategy was -4.8% in 1969, the best year for the moving average timing system was 36.2% in 1992. This pattern of gaining exposure to a majority of uptrends, and avoiding downtrends has been a shown to exist for almost 50 years of backtesting. Fundamentally investors have been fleeing high risk securities and moving to minimum risk bonds for at least this long. Fixed income investors always are looking to find yield, if they can't get the highest yields found in junk bonds due to riskiness they move somewhere, and that somewhere is at least sometimes treasury bonds. So by monitoring this switch we can effectively outpace junk or treasury bonds alone over the course of this simple backtest.
Disclosure: I am/we are long JNK, IEF.